Home Depot Inc. had earnings per share in 1992 of $0.82, and had registered
growth in earnings per share of 45% in the prior five years. The firm had
return on assets of 12.82 %, a pre-tax interest rate of 7.7%, a debt-equity
ratio of 36.59% and a retention ratio of 91% in 1992 (The tax rate was 36%).
Assuming that these levels will be sustained in the future, the growth rates
in FCFE and FCFF will be as follows:

Expected growth rate in FCFE = b (ROA + D/E (ROA -i (1-t)))

= 0.91 (12.82% + 0.3659 (12.82% - 7.7% (1-0.36))

= 14.29%

ExpectedGrowth rate in FCFF = b (ROA)

= 0.90 * 12.82% = 11.67%

The growth rate in free cashflows to equity is greater than the growth rate
in the free cashflow to the firm because of the leverage effect.

VII.FCFF STABLE GROWTH FIRM

The Model

A firm with free cashflows to the firm growing at a stable growth rate can
be valued using the following model:

Value of firm = FCFF1 / (WACC - gn)

where,

FCFF1 = Expected FCFF next year

WACC = Weighted average cost of capital

gn = Growth rate in the FCFF (forever)

The Caveats

the growth rate used in the model has to be reasonable, relative to
the nominal growth rate in the economy.

the relationship between capital expenditures and depreciation has
to be consistent with assumptions of stable growth.

Illustration 13: Valuing the Food Product Division at RJR Nabisco

A Rationale for using the Stable FCFF Model

The division is in steady state; It is a large player in a stable market
with strong competition. It cannot be expected to sustain high growth for
any length of time.

The division does not carry its own debt (though its parent company,
RJR Nabisco, carries plenty). Thus, only the FCFF can be computed for the
division.

The entire division is up for sale, not just RJRís equity stake
in the division.

Background Information

In 1995, the food products division had revenues of $ 7 billion on
which it earned $1.5 billion before interest and taxes.

The division had capital expenditures of $660 million and depreciation
of $550 million in 1994.

The working capital as a percent of revenues has averaged 5% between
1993 and 1994. (Working capital increased $350 million in 1994)

The beta of comparable firms in the food products business is 1.05
and the average debt ratio at these firms is 23.67%. (The cost of debt
at the largest of these firms is approximately 8.50%).

The tax rate is assumed to be 36%.

The cash flows to the firm are expected to grow 5% a year in the long
term

Valuing the Division

The estimated free cash flows to the firm (division) are as follows
ñ

Current

Next Year

EBIT (1-t)

$ 960.00

$ 1,008.00

- (Cap Ex - Depreciation)

$ 110.00

$ 115.50

- Change in Working Capital

$ 150.00

$ 17.50

= FCFF

$ 700.00

$ 875.00

The cost of capital is computed, based upon comparable firms (in the
food products business)

The value of the firm, in the most general case, can be written as the present
value of expected free cashflows to the firm:

Value of Firm =

where,

FCFFt = Free Cashflow to firm in year t

WACC= Weighted average cost of capital

If the firm reaches steady state after n years, and starts growing at a
stable growth rate gn after that, the value of the
firm can be written as:

Value of Firm =

Firm Valuation versus Equity Valuation

The value of equity, however, can be extracted from the value of the
firm by subtracting out the market value of outstanding debt.

The advantage of using the firm valuation approach is that cashflows
relating to debt do not have to be considered. In cases where the leverage
is expected to change significantly over time, this is a significant saving.
The firm valuation approach does, however, require information about debt
ratios and interest rates to estimate the weighted average cost of capital.

The value for equity obtained from the firm valuation and equity valuation
approaches will be the same if:

(a) Consistent assumptions are made about growth in the two approaches

(b) Bonds are correctly priced

Best suited for:

Firms which have very high leverage and are in the process of lowering
their leverage or vice versa.

The earnings before interest and taxes at Federated in 1994, which
amounted to $531 million, were still well below EBIT in 1988 of $628 million.
The earnings are expected to grow at rates slightly above-stable for the
next five years as the firm recovers.

The leverage in 1994 was still significantly above desirable levels,
largely as a consequence of the leveraged buyout in the late eighties.
It was anticipated that this debt ratio would be lowered gradually over
the next five years to acceptable levels.

Background Information

Base Year Information

Earnings before interest and taxes in 1994 = $ 532 million

Capital Expenditures in 1994 = $310 million

Depreciation in 1994 = $207 million

Revenues in 1994 = $ 7230 million

Working Capital as percent of revenues = 25.00%

Tax rate = 36%

High Growth Phase

Length of High Growth Phase = 5 years

Expected Growth Rate in FCFF = 8%

Financing Details

Beta during high growth phase = 1.25

Cost of Debt during high growth phase = 9.50% (pre-tax)

Debt Ratio during high growth phase = 50%

Stable Growth Phase

Expected growth rate in FCFF = 5%

Financing Details

Beta during stable growth phase = 1.00

Cost of Debt during stable growth phase =8.50%

Debt Ratio during stable growth phase = 25%

Capital expenditures are offset by depreciation.

Valuation

The forecasted free cashflows to the firm over the next five years are provided
below:

Why three-stage? LIN Broadcasting in a fast growing firm in
a fast growing industry segement. Revenues are expected to grow 30% a year
for the next few years.

Why FCFF? LIN Broadcasting has never made a profit after taxes,
even though it has posted high growth, because it has had high leverage
and non-operating expenses. Prior to these charges, however, it earned
a healthy operating income of $128 million in 1994. Thus, though FCFE are
negative, FCFF are positive.

The financial leverage is high but can be expected to decline as the
industry stabilizes.